A quest for relevance

New Framework for SMEs balances costs and benefits in financial reporting.

The recent efforts by the accounting profession to improve private
company financial reporting revealed a clear and strong demand by
small and medium-size entities, the CPAs who serve them, and those who
use their financial statements for a more robust and reliable
financial reporting framework when GAAP is not required.

In response to that marketplace demand, the AICPA staff and a task
force are developing a Financial Reporting Framework for Small- and
Medium-Sized Entities. The framework is intended for entities that are
not required to prepare financial statements in accordance with GAAP.

The proposed special-purpose framework is geared for simplicity. It
emphasizes historical cost over fair value. It calls for reporting of
costs when they are incurred and revenue when performance is achieved
with reasonable assurance that collection will occur.

Traditional accounting methods and accrual income tax methods are
blended into the proposed framework. Preparers who follow the proposed
framework will find that it reduces the number of Schedule M
differences that a business would have to report on its tax returns to
reconcile its financial statements to its taxable income.

As proposed, the framework is designed to facilitate the creation of
financial statements that provide users, especially banks, the
information they need without unnecessary disclosures that increase
the time and expense of preparation.

SMEs run by owner-managers are expected to find the proposed
framework especially useful, as the financial statements prepared
under the framework will confirm their assessments of performance,
describe what they owe and own, and help users understand cash flows.
The proposed framework is intended for SMEs whose financial statement
users have direct access to management, and is intended for companies
that have no intention of going public.

No concept of variable-interest entities is included in the proposed
framework, and preparers have the option of presenting parent-only
financial statements. In addition, the proposed framework will not
include a concept of other comprehensive income, and it will not
require complicated accounting for derivatives such as interest rate
swaps. Derivatives will be handled largely through disclosure,
eliminating complicated issues.

An exposure draft of the framework was released Nov. 1 at aicpa.org/FRF-SMEs, with comments
due Jan. 30. The completed framework is scheduled to be released in
the second quarter of 2013.

To provide more information on the framework, the JofA
organized a round table with AICPA Vice President—Professional
Standards & Services Chuck Landes and two members of the project
task force, Pat Piteo and Tom Ratcliffe.

The panelists

Chuck Landes is vice president–Professional Standards
& Services for the AICPA and has led the staff effort to develop
the Financial Reporting Framework for Small- and Medium-Sized Entities
(FRF-SME).

Pat Piteo is an audit partner for Cohen & Co.
Ltd. in Akron, Ohio, who provides compilations and reviews as well as
audit and attest services for clients. She is a member of the task
force that is developing the FRF-SME.

Tom Ratcliffe serves on the FRF-SME task force and is
a senior accounting and auditing technical adviser for Warren Averett
LLC in Montgomery, Ala.

Here are excerpts from that conversation:

Tysiac: How will this framework change private company
financial reporting?

Landes: The framework focuses on historical cost
because what we have heard for several years now is that most users of
small business financial statements are interested in the cash flow.
Fair value accounting doesn’t impact cash flow, and it’s more
expensive to use. For example, a banker wants to know that an entity
has the cash flow necessary to pay its loan. An insurance company
wants to know that a small business, if they’re giving a bond on
performance, has sufficient cash flow out of their construction
operations to complete the project. And so what we’ve been hearing
over probably the last five years is that a lot of the new accounting
standards simply are not relevant to the needs of users of small
businesses. So … the No. 1 difference [between the Framework for SMEs
and U.S. GAAP] will be that this framework really does not use fair
value except in a few areas. It’s based on historical costs.

The second major difference is that there are more options built
into the framework that will allow a practitioner working with his or
her client to tailor the presentation to the needs of a user. Let me
just give you a quick example. Many bankers [work with] small
businesses that might have their real estate in a separate partnership
or a separate company. Under generally accepted accounting principles,
[the businesses] have to consolidate that real estate in with their
operations. And the banker may say to the small business owner, “I
know all about your real estate operation because I hold the mortgage
on that. What I want to see is just a picture of your operations.”

And today the small business owner has to say, “Well, under GAAP, I
have to consolidate that.” And it’s very frustrating to both the owner
and the user, not to mention the CPA who is trying to serve this
client, not to be able to provide something to the user that is
relevant and cost-effective. So that’s going to be another change that
folks will see, there is some optionality built in here for the CPA
working with a small business client to tailor some of the
disclosures, to tailor some of the accounting to meet the needs of the users.

So the two major changes are almost no fair value, and secondly,
more optionality introduced, which, as a result, will really make the
financial statement preparation more cost-beneficial and more relevant
to the end user.

Tysiac: What niche will this fill in the marketplace? Why is
there such a great need for this framework?

Landes: I’d say the need really comes about as a
result of the frustrations around some of the more costly accounting
standards that small businesses have to comply with if they follow
GAAP. We’ve been hearing some of these complaints [for years] … So
what we’re trying to do is serve a marketplace where GAAP financial
statements are not necessary. The user, however, wants a good, solid
accounting framework, one that’s been through due process, that they
know the CPA professional has been involved with, and one that will
provide more relevant financial information.

Tysiac: Is it important to be clear that the framework is not
in competition with GAAP, that it’s intended for businesses that are
not required to file financial statements that are prepared in
accordance with GAAP?

Ratcliffe: That is unquestionably the truth. In fact,
this framework we are developing is a special-purpose framework that
is by definition not U.S. GAAP, or GAAP at all under any meaning of
GAAP under the AICPA Code of Professional Conduct. So it is
not a GAAP framework, but it is self-contained, it is robust, and it
is a framework that can be used by a variety of different entities.
[The framework is] a little more than 200 pages with a companion
volume that will be [released along with the final framework] to help
folks in some implementation issues.

Tysiac: Are CPAs themselves going to have to play key roles in
the marketing of the framework, spreading the word? How do they
pitch it to their clients?

Piteo: CPAs are going to have to have a real role in
marketing this. I don’t think that this will be a tough sell to our
clients at all. We’re on the front lines. We’re hearing a lot of
complaints about the excess disclosures and requirements. I think the
real sell has to be to the external user for these clients. We as CPAs
have to educate the bankers so that they’re comfortable requesting
these financial statements under this framework. Again, I don’t think
that will be a tough sell.

Tysiac:I’ve heard the framework described as
“principles based” rather than “rules based.” Is this the case, and
why does this make sense for this kind of company?

Landes: I suspect the reason you’re hearing that is
that what we’re trying to do with the framework is not to create pages
and pages and pages of guidance and interpretations. The term
“principles based” versus “rules based” gets confused oftentimes. Even
most rules are based on good principles. The difference is the
quantity of material that one has to look at and the number of bright
lines presented.

What we’re doing here is essentially creating a framework where
everything is going to be in one document, a little more than 200
pages. So if you want to research something on how to account for a
certain transaction, it’s going to be easy to find.

The flip side, and this goes to your question of principles based
versus rules based, is that we won’t have tons and tons of bright
lines. So practitioners will have to say, “OK, I understand the idea
here. Now I’m going to have to apply my own professional judgment in
looking at the actual facts and circumstances of my client and advise
them on the right way to do that.” It’s a good thing in that I think
it does allow practitioners to use their professional judgment.

Tysiac: The AICPA has proposed changes to auditing standards
that would pave the way for audits of the Framework for SMEs. Will
the framework have any benefits from an auditing
perspective?

Piteo: I think in eliminating some or all of the fair
value requirements and disclosures, that’s going to reduce the audit
work we have to do in that case. Especially in smaller companies,
getting valuations of things like goodwill makes the audit very
difficult and much more expensive than it needs to be for the benefit
of that information. The use in [compilations] and reviews is where
you’re going to see the beginning of it, but I definitely see it
having a good aspect in audits, too, for our smaller clients who just
have requirements from their bank.

Tysiac:Would there be a post-implementation
review of the framework, and when would that take place?

Landes: What we think we’ll have is a very stable
platform, if I can use a computer analogy. And therefore let’s not
tinker with it. Let’s not come back and keep telling practitioners,
“This is changing. That is changing.” Let’s just set it out there for
three, four years—I can’t tell you exactly what that time frame will
be—and then we’ll come back and visit it.

Tysiac: What will success look like for this framework five
years from now?

Ratcliffe: I would say success would be that you will
see more and more financial statements prepared using this framework.
I think we have a real potential of achieving that goal … It will be a
success for all stakeholders who for years have been saying that
something like this needed to be developed, and I think that probably
will be within that five-year threshold.

Piteo: I just look at success as being defined as
acceptance, that this is out there and accepted by banks and used by
our clients so that they can get the benefits of this. So in five
years, I hope all my clients that are smaller than a certain amount
are using this and having the banks accept it.

Separate initiatives for private companies

Two major developments in private company accounting and financial
reporting over the past year have separate constituents. Here is a
brief summary about each private company initiative:

Framework for SMEs:

Developed by AICPA

For use by non-GAAP filers

Comments on ED due Jan. 30

Final version expected 2Q 2013

Private Company Council:

Formed by Financial Accounting Foundation

Creating exceptions for filers that use U.S. GAAP

Meets for first time Dec. 6

Timetable for exceptions uncertain

EXECUTIVE SUMMARY

The new Financial Reporting Framework for Small- and
Medium-Sized Entities that is being developed by the AICPA will
focus on historical cost and provide CPA practitioners who
are working with small business clients more options to tailor
financial statements to the needs of users.

SMEs that are not required to prepare financial statements in
accordance with GAAP will be able to use the framework to
produce financial reporting that is relevant to users at a reasonable cost.

When completed, the project is expected to produce a framework
of a little more than 200 pages along with a companion
volume to aid implementation.

The framework will be designed to be a relatively stable
document because preparers of small business financial
reports often complain that frequent changes to accounting standards
create unnecessary complexity. After the framework is completed, it
may take three or four years before it is reviewed and updated.

CPAs will need to educate the bankers who are the primary
users of financial statements prepared for their small
business clients on the benefits of using statements prepared under
the framework.

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